We model a market populated by two groups of boundedly rational agents: “newswatchers” and “momentum traders.” Each newswatcher observes some private information, but fails to extract other newswatchers' information from prices. If information diffuses gradually across the population, prices underreact in the short run. The underreaction means that the momentum traders can profit by trend‐chasing. However, if they can only implement simple (i.e., univariate) strategies, their attempts at arbitrage must inevitably lead to overreaction at long horizons. In addition to providing a unified account of under‐ and overreactions, the model generates several other distinctive implications.

We model a market populated by two groups of boundedly rational agents: “newswatchers” and “momentum traders.” Each newswatcher observes some private information, but fails to extract other newswatchers' information from prices. If information diffuses gradually across the population, prices underreact in the short run. The underreaction means that the momentum traders can profit by trend‐chasing. However, if they can only implement simple (i.e., univariate) strategies, their attempts at arbitrage must inevitably lead to overreaction at long horizons. In addition to providing a unified account of under‐ and overreactions, the model generates several other distinctive implications.

This study provides an explanation for the anomalous significantly negative price-earnings relation using the simple earnings capitalization model for firms that report losses. We hypothesize and find that including book value of equity in the valuation specification eliminates the negative relation. This suggests that the simple earnings capitalization model is misspecified and the negative coefficient on earnings for loss firms is a manifestation of that misspecification. Furthermore, we provide evidence on three competing explanations for the role that book value of equity plays in valuing loss firms. Specifically, we investigate whether the importance of book value in cross-sectional valuation models stems from its role as (1) a control for scale differences (Barth and Kallapur 1996), (2) a proxy for expected future normal earnings (Ohlson 1995; Penman 1992), or (3) a proxy for loss firms' abandonment option (Berger et al. 1996; Barth et al. 1996; Burgstahler and Dichev 1997). Our results do not support the conjecture that the importance of book value in cross-sectional valuation stems primarily from its role as a control for scale differences. Rather, the results are consistent with book value serving as a value-relevant proxy for expected future normal earnings for loss firms in general, and as a proxy for abandonment option for loss firms most likely to cease operations and liquidate.